Behind the ETF curtain

The barrage of regulator reports and comments on ETFs has brought to light some of the activities inside ETFs, securities lending is one of these. Paul Burgin asks asset managers what they think of the practice

Deutsche Bank’s July Industry Perspective highlighted the importance of securities lending within the ETF industry. While the practice can generate attractive revenues to offset total expense ratios (TERs), it is not without its risks. ETF providers are not the only parties debating whether the practice is right or wrong. Nor are they the only parties making use of stock lending.

Stock lending is nothing new. Mutual funds and pension providers have lent out stock for many years, generating returns that add to profits, reduce overall investment costs or boost fund performance. Not all active managers indulge in lending. Skandia, Jupiter and Standard Life Investments do not lend stock but have no specific policies about it or about investing in ETFs that lend out underlying assets.

Few advisers have specific policies barring investment in stock lending products. Martin Bamford, managing director of Informed Choice, has a typical attitude towards it. He says: “I have not got too many concerns about stock lending, assuming it is within reasonable limits and properly disclosed. Used well, it can generate revenue which can reduce the cost of funds.”

His key concern is a ‘perfect storm’ where stock is not returned and the collateral put up against the stock turns out to be toxic. Although possible, Bamford believes the chances of it happening are slim. “In practice, it is very unlikely that ETF providers would ever find themselves in this position and the benefits of stock lending probably outweigh any disadvantages,” he says.

Steven Keshishoghli of Fund Intelligence, a discretionary manager, also cites return of collateral as a key issue. Advisers and clients of his firm are warned that offshore domiciled ETFs may not by covered by consumer protection schemes in the event of a product failure.

Keshishoghli is also surprised about the general lack of awareness and concern in the advisory sector. He recently attended a meeting with a leading absolute return fund manager who invests in ETF Securities physical gold product. He says: “Although ETFS does not lend out its gold, we asked the manager about it in order to test his level of knowledge. Other advisers in the room were not even aware of the issue. I would have thought professionals would be asking more questions.”